The con is on: how carbon credits neuter Cap & Trade

In my discussion of the Cap & Trade scheme for carbon dioxide equivalent (CO2E) emissions (greenhouse gases) proposed by U.S. Reps. Henry Waxman, D-Calif., and Edward Markey, D-Mass. (the American Clean Energy and Security (ACES) Act of 2009), I argue that the two key issues are (1) the size of the overall quota and (2) the enforcement of the rule that without a permit, you cannot emit.

Prima facie, the scheme looks tough. The Discussion Draft Summary of the American Clean Energy and Security Act of 2009 reads: “The draft establishes a market-based program for reducing global warming pollution from electric utilities, oil companies, large industrial sources, and other covered entities that collectively are responsible for 85% of U.S. global warming emissions. Under this program, covered entities must have tradable federal permits, called “allowances,” for each ton of pollution emitted into the atmosphere. Entities that emit less than 25,000 tons per year of CO2 equivalent are not covered by this program. The program reduces the number of available allowances issued each year to ensure that aggregate emissions from the covered entities are reduced by 3% below 2005 levels in 2012, 20% below 2005 levels in 2020, 42% below 2005 levels in 2030, and 83% below 2005 levels in 2050.”

In fact, the scheme is a total con. It permits the US to increase CO2E emissions until 2020. The escape mechanism used – carbon offsets or carbon credits – suggests that for the period 2020 – 2050 also, the supposed intent of the Act – to reduce CO2E emissions in the US – will be neutered.

Provided the secondary markets for permits are efficient, Cap & Trade is equivalent to a tax on CO2E emissions. They both have the same informational requirements for the policy authorities/regulators: the authorities must be able to monitor and measure the actual volume of CO2E emissions. That is not a minor challenge, because there are many sources of CO2E emissions, and many of them are either hard to monitor or too small-scale to warrant the fixed cost of monitoring. That’s why ACES exempts entities that emit less than 25,000 tons per year of CO2 equivalent. So my father-in-law’s barbecue activities will probably be exempt. That is just as well, as his grilled swordfish is to die for. Monitoring and measuring the actual volume of emissions is difficult, but in principle it can be done in a way that can be independently verified.

Carbon offsets: a con for our time

The ACES bill allows polluters to purchase up to 2bn tonnes a year in carbon “offsets”, over and above the total allowance provided by the permits of the Cap & Trade scheme. This 2bn-tonne annual offset allowance exceeds all the CO2E emission reductions envisaged between now and 2040! As further icing on the environmental cake, many of these offsets could be purchased overseas (and be based on overseas ‘carbon offset operations’), and would therefore not reduce US domestic emissions, even if they reduced overseas emissions (which they probably won’t anyway, as I argue below).

What is a carbon offset or carbon credit? A carbon offset or credit is the right to an additional allowance to emit greenhouse gases, which is created by some activity or investment that has reduced carbon emissions, or rather, that is alleged to have reduced carbon emissions, based on some counterfactual, hypothetical scenario. This credit can be sold by the originator to interested parties such as a US utility that wishes to emit more CO2E than the sum of its free allowance and any additional purchases it has made of additional permits in the secondary market for permits.

An example is tree planting. Joe Bloggs plants a bunch of trees, say in a re-forestation project in the Amazon jungle. A number is put on the amount of C02 that will be absorbed by these additional trees. This becomes a carbon offset or carbon credit that can be sold by Joe to some avid polluter in America. What’s wrong with this? Nothing, except that the claim about the additional CO2 that will be absorbed by the tree planting project is non-verifiable. Even if we can determine exactly how much CO2 will be absorbed by the re-forested patch of jungle between now and Kingdom Come, we still don’t know what we need to know. What we need to know is how many of these additional trees would have been planted in the absence of the carbon offset or carbon credit scheme. If Joe would have planted the same number of trees in any case, even without the incentive of the revenue from the carbon offsets/credits, the project is not ‘additional’.

It gets better. Carbon credits/offsets have been awarded not just for planting trees, but also for not cutting them down. The logic is impeccable – if without the carbon offsets I would have cut down the trees, CO2 absorption would have been lower, so the scheme is additional – but non-verifiable. “Hello, Honey! Busy day again. Been hard at it, not cutting down those trees again. Money’s on the way.” It’s rather like a counterfactual version of the set-asides of US and EU agricultural policy.

For carbon offsets or carbon credit schemes to work you don’t just have to monitor and measure actual carbon emissions. You have to be able to monitor and measure carbon emissions in a hypothetical, counterfactual ‘parallel’ universe in which the carbon offset scheme does not exist. We can build mental, mathematical models of that hypothetical, counterfactual universe, but we cannot measure it objectively, the way we can, in principle, measure actual emissions. Controlled experiments are not possible. Natural experiments are likely to be few, far between and of dodgy quality.

So how does one establish the degree of additionality of schemes and projects that are proposed as candidates for carbon credits or carbon offsets generating activities or investments? Well, you hire an expert. I know there are honest and incorruptible experts. I also know that there are sufficient numbers of dishonest, corruptible experts who will certify anything for the right price. I fear that any claim to additionality for even the wonkiest carbon-offsets generating project will be certified by some unscrupulous, dishonest expert, agency or business. The shameful recent experience of the rating agencies in the rating of complex structured financial products shows how low experts and professionals will stoop if the price is right.

This generalised “trahison des clercs” has produced a vast and growing industry of verifiers and certifiers of candidate carbon offset producing projects, investments and activities. No doubt there are competent, well-intentioned and honest practitioners of the CO2E additionality arts. The problem is, we will never know. We have to take the word of experts and professionals who are exposed to the most naked conflict of interest. There have already been reports of claims for carbon credits/offsets that were so blatantly ridiculous (including the repeated not cutting down on the same patch of hardwood forest). The world will be taken for a massive ride if we don’t kill the whole carbon offsets/carbon credits business outright.

The political economy of the birth of this demented carbon credit/offset scheme was the perception in the rich industrial countries that the developing countries had to ‘get something’ out of the war on global warming. Perhaps they should. Carbon credits/offsets, however, are not the way to do it. An elaborate con, employing mainly consultants and specialised businesses from the advanced industrial countries, is not a solid foundation for economic development.

Aha!

Given the reality that ACES allows CO2E emissions to be increased, effectively indefinitely, some of the more bizarre features of the law make more sense. There is no economic problem (‘just’ a breach of faith) with the fact that Candidate Obama’s election promise that 100 per cent of carbon trading permits would be auctioned off in the carbon market has been scrapped. About 85 per cent of the allowances will be given away to various interested and hard-lobbying parties in the energy sector; local electricity distribution companies are scheduled to receive 35 per cent of the permits.

The initial allocation of the permits is a distributional issue, not an efficiency issue. It determines how the scarcity rents created by the permits are allocated. It need not interfere with the efficient abatement of CO2E emissions, as long as the allocation does not depend on current and future planned or expected emission volumes. Even if all permits are given free of charge to the biggest historical polluters, they will have a scarcity value (opportunity cost) to these historical polluters. They can keep them and continue to pollute, or they can sell them in the secondary market for permits. If this secondary market for permits is reasonably efficient (admittedly an untested conjecture), the right signals will be given to ensure that the mandated overall reduction in emission volumes is achieved in the most cost-efficient manner.

But what does not make even an ounce of sense in the draft ACES law, is that regulators will be required to ensure that distributors and other recipients of free permit allocations, pass on the full value of these allowances to the consumer. Consumers, whose energy demand is the ultimate cause of the CO2E emissions, will therefore have no financial or price incentive to reduce their energy consumption. The allocations of permits to the energy producers will have no value to these energy producers, because they have to pass the scarcity rents on to the consumers.

The result is that the entire permit scheme does not alter the price or quantity constraints faced by any participant in the CO2E scheme. Therefore, emissions will not be reduced. But that is inconsistent with the supposed desire to reduce emissions to 83 percent of their 2005 level by 2020 and to 17 percent of the 2005 level by 2050. Except that is it not inconsistent if there is no intention to reduce emissions at all, but instead every intention to permit them to be raised above their 2005 levels. And that is of course what is going on.

A similar sleight of hand can be found in another part of the ACES Act – ‘the renewable electricity requirement’. This begins at 6% in 2012 and gradually rises to 25% in 2025. But the governor of any state may choose to meet one fifth of this requirement with energy efficiency measures. This means that the renewable energy objective is emasculated by allowing power companies to count efficiency savings as part of their renewable energy target. Think about it. Energy savings already get rewarded, because you need fewer CO2E emissions permits. Counting them in addition as a contribution to renewable energy is double counting.

Conclusion

The American Clean Energy and Security (ACES) Act of 2009 is worse than nothing: it is a con and a fraud. It pretends to be a vehicle for reductions in CO2E emissions. In fact it is designed to permit increases in CO2E emissions.

Reducing CO2E emissions is painful. America doesn’t do pain any longer. Be it the environmental or the fiscal arena, only painless solutions are politically acceptable and feasible. When there are no painless solutions, problems are allowed to fester and grow until they finally blow up. It is time for America to grow up and to accept that there are problems for which there are no painless solutions.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.